On July 25, the SEC issued a Rule 21(a) investigative report concluding that the sun rises in the east and sets in the west. No, wait, that’s not right. The report actually concluded that tokens offered by an unincorporated “virtual organization” known as The DAO (presumably short for “decentralized autonomous organization”) in what is known as an “initial coin offering” (ICO) were securities and, therefore, are subject to the federal securities laws.
Despite loads of cool-sounding techno-jargon in The DAO’s marketing materials and multiple breathless articles by mainstream media touting ICOs as the next big thing, the SEC had no trouble slotting The DAO tokens into the U.S. Supreme Court’s 71-year-old Howey definition of a “security,” which should come as no surprise to anyone.
What’s going on?
ICO’s have sprung out of nowhere in the past couple of years to rival traditional venture capital in the amount of funds raised for early stage technology projects. In fact, Shawn Langlois, social media editor of MarketWatch, said in a recent column that “the total crypto market cap now stands at a whopping $87 billion.”
Basically, promotors sell virtual coins in ICOs in exchange for U.S. currency or some other form of virtual currency (for example, bitcoin or ether). The ICO proceeds are then ostensibly used to fund development of the company’s digital platform, software or other technology project. The virtual coins typically can be resold in a secondary market on virtual currency exchanges.
Not surprisingly, the SEC says in its related Investor Bulletin that “some promoters … may lead buyers of the virtual coins … to expect a return for their investment or to participate in a share of the returns provided by the project.” And therein lies the problem.
Way back in 1946, the Supreme Court held in SEC v. W.J. Howey Co. that a security exists when something sold for value represents an ownership interest in a common enterprise and the purchasers have a reasonable expectation of profits from the managerial efforts of others. In the case of The DAO, the SEC applied a facts-and-circumstances test to conclude that the sale of The DAO tokens met the Howey standard. This means that the offer and sale must either be registered under the Securities Act of 1933 or exempt from registration, neither of which occurred in this instance. Among other negative consequences of an illegal, unregistered offering are that the promoters can be held personally liable and purchasers have a statutory right to rescind their purchase and be refunded their purchase price with interest. Various other laws may be implicated, including broker/dealer licensing and Investment Company Act compliance.
Nevertheless, in an apparent fit of prosecutorial largesse and perhaps in acknowledgement of the mind-boggling growth and complexity of this new market, the SEC decided not to bring charges against The DAO’s promoters and ICO participants or to make a finding of securities law violations. Rather, it chose to issue a Rule 21(a) report “to caution the industry and market participants.” (Section 21(a) reports are a means by which the SEC communicates general policy-level information to the market following its investigation into potential wrongdoing by a particular company.)
The SEC underlined its concern, however, by cautioning the public in its ICO Investor Bulletin that fraudsters might “use innovations and new technologies to perpetrate fraudulent investment schemes,” which is shocking news indeed.
What happens next?
It is appropriate to point out that many legitimate businesses have arisen out of just such cutting-edge technology innovations as this and that by no means are all promoters of, and participants in, ICOs attempting to perpetuate fraud. It should also be noted that not all virtual coins are necessarily securities. For example, those that are exchangeable for a particular product or service, perhaps similar to an investment in a Kickstarter project, or have some other practical application apart from the expectation of profits through the efforts of others may not be deemed to be securities.
That being said, one wonders what will happen next. One likely outcome of the SEC’s report is that savvy promoters will quickly massage their marketing materials to avoid references to investment, expectations of profits or similar language that invokes Howey. On the other hand, one might also expect many such enterprises to charge boldly ahead until the SEC demonstrates its willingness and ability to track down and prosecute violators, which is likely to be devilishly tricky given the virtual world in which they operate. It is also possible that the SEC’s position causes ICOs to migrate toward the traditional capital markets in order to “legitimize” their operations and thus expand their potential investor base.
In any case, it will be fascinating to watch how this plays out.
All the best,